Investments that can kill…

“Leverage, concentration and illiquidity are the three things that can kill you”

Steve Cohen‘s words provide real guidance in the current low reward investing world. What specifically does he mean by this and how could it kill your investments?

Leverage gets more investors in trouble than probably any other single factor. The best way I can describe it is that its Gambling with money you don’t have. Yes banks or investment pros may say, we can put $10,000 down but we can leverage that up to $1 million, and you can earn the returns of that. You need to be prepared to lose all your funds if something should go wrong. While you benefit from extraordinary gains when the investments succeeds, should something go wrong, even only a little bit, your total investment could be lost. Only the really experienced should attempt to use leverage if there is risk involved. If you’re utilizing leverage you need an investment edge and if you don’t have an edge then don’t do it no matter what the returns.

Leverage can enable you to borrow 100% of your investment, which means you’ve increased your return by 2X. It also means you’ve increased the potential volatility by 2X as well. A 5% increase in value offers you 10% returns, a 10% loss in value hits you by 20% of your investment. In volatile markets that allow extreme leverage this can be particularly dangerous. FX markets often allow much more than 2X leverage. $10 can be leveraged into $100 which means 100% of your capital can be wiped out by just a 10% move. In a market like the FX markets where 10% moves are uncommon, but not unheard of, this is a crazy way to try to generate returns. Imagine if you had a position with the Swiss Franc, which just moved by 15% in a day (was up 30% in a few hours vs the Euro). If you were leveraged 10-1, that move would have left you wiped out and owning 50% of your initial investment… because of leverage.

Concentration (meaning a portfolio with only a few positions) can be a double edged sword. When its done right, a concentrated portfolio will help generate big winners (such as Warren Buffett betting a lot on the potential for success with Insurer Geico, American Express) and it will cause big losers too. The key is knowing your market. Don’t go all-in on an opportunity if you don’t have an exit strategy and don’t have an investment edge. Most people don’t have either and therefore have no business investing with a concentrated portfolio.

Using leverage means you’re a gambler, not an investor. This is further multiplied when it’s done in a concentrated portfolio position. You’re narrowing all your risk down to a few assets and then leveraging. Many investors had bet a lot of their money in the Euro-Swiss franc investments. Or had borrowed Swiss Francs for a lower interest rate while earning in other currencies- they were concentrating their investments and concentrating their risk. And as we now know, the Swiss National Bank move- removing the Euro link- resulted in widespread illiquidity which made the market losses that much worse.

Illiquidity is an investors worst nightmare. There is nothing worse than wanting to exit an large investment but either the investment can’t be sold OR there are no buyers. Invest mostly in liquid positions. You can’t have an exit strategy if you’re trapped in a position and if you have most of your investments here, what happens if you need the cash or a better opportunity comes along- you’re stuck.

I think there’s a good rule of thumb that comes from all of this. Most of us really don’t need to use leverage in our portfolios.

Yes, leverage can be a useful tool in the right hands, but what leverage does to most portfolios is increase the probability of a tail risk event thereby increasing the risk of permanent loss.

So, when the Swiss National Bank comes in and does something that no one expects then a 20% move turns into a 100% loss for a lot of leveraged asset holders. No one needs that sort of added risk in a portfolio. So, when in doubt, stick to the old Warren Buffet rule: “don’t invest in what you don’t understand”. Odds are, you don’t understand leverage and don’t need to.

For most of us, investing is actually just the act of allocating our savings. Unfortunately, the allure of “beating the market” and the myth that we’ll “get rich quick” in the markets is powerful and leads people to do things that are often irrational. When in doubt avoid leverage.